SOURCES OF FINANCE

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PART 1 Function LEARNING OUTCOMES For many businesses, the issue about where to get funds from for starting up, development and expansion can be crucial for with regard to the success of the business. It is important, therefore, that you With the” merger" different funds understand the various sources of finance open to a business two or more used in a and are able to assess how appropriate these sources are in companies join enterprise relation to the needs of the business. together in a students should unique business A finance source, or financing method, helps an organization to be able to satisfy short-term operating needs, such as paying for costs of describe what materials, salaries and other administrative expenses. Financing are internal and also helps leadership plan for long-term such as expansion external projects ( mergers and acquisitions). financial sources and the Significance differences among these. Financing is a significant business practice in modern economies. A firm with no access to financial markets, or unable to raise funds privately, may have difficulties operating. Senior leaders may be unable to set long-term goals without funding. Types

There are external and internal sources of finance; the types Equity is the amount of financing products vary, but the most common are equity and products. Equity products include shares of common of the funds stock and preferred stock. Debt products include bonds, private contributed by the loans and overdraft agreements. owners (the stockholders) ;it is Internal Sources also the amount of the stocks issued Traditionally, the major sources of finance for a limited company are internal sources:  Personal savings  Retained  Sale of To recruit means to enroll Personal Savings or to hire new Quite simply, personal savings are amounts of money that a members business person, partner or shareholder has at their disposal to ( employees ) do with as they wish. If that person uses their savings to invest in their own or another business, then the source of finance on behalf of an comes under the heading of personal savings. employer

There are many examples where business people have used substantial sums of their own money to help to finance their businesses. A good and very public example here is Jamie Oliver, the television chef. Jamie financed his new restaurant, 'Fifteen', using fifteen raw recruits to the catering trade and a large amount (£500,000) of his own .

Retained Profit PROFIT This is often a very difficult idea to understand but, in reality, it is very simple. When a business makes a profit and it does not spend it, it keeps it - and accountants call profits that are kept and not spent retained profits. That's all.

The retained profit is then available to use within the business to help with buying new machinery, vehicles, computers and so on or developing the business in any other way. Retained profits are also kept if the owners think that they may have difficulties in the future so they save them for a rainy day! “Rainy day”stands Working Capital for” the future time of need” This is the short-term capital or finance that a business keeps. Working capital is the money used to pay for the everyday trading activities carried out by the business - stationery needs, staff salaries and wages, rent, energy bills, payments for supplies and so on. Working capital is defined as:

Working capital = current assets - current liabilities

Where: Cash in hand means funds current assets are short term sources of finance such as debtors that are and cash - the amount of cash and cash equivalents - the immediately business has at any one time. Cash is cash in hand and deposits available to a payable on demand (e.g. current accounts). Cash equivalents business, and are short term and highly liquid which are easily can be spent as needed and immediately convertible into cash. current liabilities are short term requirements for cash including trade creditors, tax owing, owing - the BALANCE SHEET amount of money the business owes to other people/groups/businesses at any time that needs to be repaid Assets Liabilities within the next month or so. Long Equity term Sale of Assets assets

Business balance sheets usually have several fixed assets on them. A fixed is anything that is not used up in the Short Liabilities production of the good or service concerned - land, buildings, term fixtures and fittings, machinery, vehicles and so on. At times, assets one or more of these fixed assets may be surplus to requirements and can be sold.( the entrepreneur might have a capital gain or capital loss).

Alternatively, a business may desperately need to find some cash so it decides to stop offering certain products or services and because of that can sell some of its fixed assets. Hence, by selling fixed assets, business can use them as a source of finance. Selling its fixed assets, therefore, has an effect on the potential capacity of the business .

Office buildings may be part of a firm's assets that could be sold off in times of slowdown in activity to raise finance.

KEY POINTS

INTERNAL SOURCES: amount of capital made by the activity of business

PERSONAL SAVINGS: own money not used to buy goods or services

RETAINED PROFIT: profit made by the activity of the business and not spent

WORKING CAPITAL: short-term capital used in a business to pay current liabilities

SALE OF ASSETS: sale of assets used in a firm( machinery, buildings, land,..)

External sources/Non-Ownership Capital

The principal types of are:

 Ownership capital  Debt financing  Overdraft facilities  Lines of credit from creditors  Grants  Venture capital  Factoring A is a payment  Leasing made by a corporation to its shareholder as a distribution of profits. (equity financing) Ownership Capital In this context, 'owners' refers to those people/institutions who are shareholders. Sole traders and partnerships do not have shareholders - the individual or the partners are the owners of the business but do not hold shares. Shares are units of in a limited company, whether it be a public or private limited company.

Equity financing helps top leadership raise funds by selling shares of equity, or stocks, on securities exchanges. A shareholder, also called stockholder, receives regular dividend payments and makes profits when prices rise.

Shares can be issued and paid either:

 at par,  at a premium.

Shares can be issued and paid by instalments An annual general Shares are generally broken down into two categories: meeting is a meeting that official bodies and  Ordinary shares associations involving  Preference shares shareholders. An AGM is held every year to elect

the board and inform Ordinary Shares their members of previous and future Ordinary shares are also known as equity shares and they are activities and to approve the most common form of share in the UK. An ordinary share the balance sheet gives the right to its owner to share in the profits of the

AN ORDINARY SHARE company (dividends) and to vote at general meetings of the company.

Since the profits of companies can vary wildly from year to year, so can the dividends paid to ordinary shareholders. In The primary market is bad years, also known as new issues dividends may be nothing whereas in good years they may be substantial. Some businesses may choose to pay marketout a dividend. Here, the even if it has had a difficult trading year and hastransaction made a loss is. conducted between the issuer and The nominal value of a share is the issue value ofthe the buyer. share - it is the value written on the share certificate that all shareholders will be given by the company in which they ownIn shares. secondary market,( second hand market or The market value of a share is the amount at whichaftermarket) a share is the being sold on the stock exchange and may be radicallysecurities different issued in the from the nominal value. primary market are bought and sold. Here, When they are issued, shares are usually sold for cash, at par you can buy a share and/or at a premium. Shares sold at par are sold for their nominal value only . directly from a seller and the stock exchange or If a share is sold at a premium, as many shares brokerare these actsdays, as an then the issue price will be the par value plus an intermediaryadditional between premium. two parties.[

PART 2

Ordinary shares are the riskiest form of investment in a company since there may be no dividends paid and the market value of shares might fall after they have been bought. A very good example of the latter case relates to shares in Ryanair - take a look at this graph of their share price.

Data source: Yahoo Finance The price can

The Ryanair share price fell so dramatically in mid-January 2004 because the company announced that its profits for the Increase plummet current financial year would probably be worse than they had previously expected.

Marconi corporation plc suffered a similar fate in terms of its share price which suddenly collapsed following announcements of serious financial problems within the group. Take a look at how their share price has since recovered: Private limited company offers limited liability for its shareholders but it places certain restrictions on its ownership, defined in Don't forget that the is actually just a second the company's by laws hand share market so even though no company ever wants its or regulations and are share price to collapse. However, with such a depressed share meant to prevent any price, companies might find it very difficult to raise additional hostile takeover finance or reassure existing creditors that they are a worthwhile attempt.(shareholders risk. cannot sell or transfer their shares without If you look at the share price pages in newspapers such as the offering them first to Financial Times, The Times, The Guardian and so on, the other shareholders for prices you will see there are mainly ordinary share prices. The purchase, or importance of share prices to a business is that it gives an shareholders cannot indication of the value placed on the company by the market - offer their shares to the for example if a company has 10 million shares and the current general public over a price is 500p each, then the value of the company - its market stock exchange and the capitalisation - is £50 million. If the share price plummets to number of shareholders 200p the company would only be 'worth' £20 million. In such cannot exceed a fixed cases, companies become possible targets for takeovers! figure ). A public limited company ( plc) is a type of public Preference Shares company whose shares may be freely sold and Preference shares offer their owners preferences over ordinary traded to the public. shareholders. There are two major differences between ordinary and preference shares:

 Preference shareholders are often entitled to a fixed dividend even when ordinary shareholders are not.  Preference shareholders cannot normally vote at general meetings.

The preference dividend is fixed in the sense that preference shares are often issued with the rate of dividend fixed at the time of issue

Preference shares are usually cumulative and this means that if this year's dividend wasn't paid, then it will be carried forward to next year. A preference share may be redeemable which means that at some time in the future, the company will effectively buy it back.

Finally, preference shares may be convertible. If the shares are convertible then the shareholders have the option at some stage of converting them into ordinary shares.

There are no upper or lower limits on authorized share capital for private limited companies, but a public limited company (plc) must have an authorized share capital of at least £50,000.

Debt Financing

In a debt financing program, a firm issues regular bonds or convertible bonds on financial markets. A buyer of bonds, otherwise known as a bondholder, receives periodic payments during the bond term. The principal amount is refunded at maturity.

Overdraft Facilities

Many companies have the need for external finance but not necessarily on a long-term basis. A company might have small cash flow problems from time to time but such problems don't call for the need for a formal long-term loan. Under these An example of line of circumstances, a company will often go to its bank and arrange credit from creditors an overdraft. Bank overdrafts are given on current accounts and the good point is that the interest payable on them is calculated Take a look at any on a daily basis. So if the company borrows only a small company's balance sheet amount, it only pays a little bit of interest. and see how much they have under the heading Lines of Credit from Creditors of 'Creditors falling due within one year' - let's This source of finance really belongs under the heading of imagine it is £25,000 for working capital management since it refers to short term credit. a company. If that By a 'line of credit' we mean that a creditor, such as a supplier company is allowed an of raw materials, will allow us to buy goods now and pay for average of 30 days to them later. pay its creditors then we can see that effectively it Grants has a short term loan of £25,000 for 30 days . Grants can be an attractive aspect of a company's financing structure. If a company has a specific issue that it wants or needs to deal with then it could find that there are grants available from local councils and other bodies that will help to pay for it. Did you know?

Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, limited period of time.

Venture Capital

Venture Capital has become a vital aspect of the source of finance market over the last 10 to 15 years. Venture Capital can be defined as capital contributed at an early stage in the development of a new enterprise, which may have a significant chance of failure but also a significant chance of providing above average returns and especially where the provider of the capital expects to have some influence over the direction of the enterprise. Venture Capital can be a high risk To run a business strategy. means to manage a business ( i.e. like a Business Angels invest own wealth in new and growing chief or chief businesses in return for a share of the equity. executive officer)

They usually have considerable experience of running businesses that they can place at the disposal of the companies in which they invest. Business angels invest at all stages of business development, but predominantly in start- up and early stage businesses.

The general profile of a business angel style of relationship is that:

 you are prepared to give up some of the equity in your business and allow an to take a 'hands-on' role  your business has the potential to grow sufficiently over the next few years to provide the business angel with a return on investment  you can offer the business angel an 'exit' (e.g. through a The invoice is a trade sale or the repurchase of their equity stake) at document issued some future date by a seller .It contains Factoring compulsory the goods price and Factoring allows you to raise finance based on the value of VAT ( value your outstanding invoices. Factoring also gives you the added tax). opportunity to outsource your sales ledger operations and to use more sophisticated credit rating systems. Once you have set up VAT is a common a factoring arrangement with a Factor, it works this way: tax in Europe. Once you make a sale, you invoice your customer and send a Each country can copy of the invoice to the factor and most factoring apply different arrangements require you to factor all your sales. The factor tax rates. pays you a set proportion of the invoice value within a pre- arranged time - typically, most factors offer you 80-85% of an invoice's value within 24 hours. The major advantage of factoring is that you receive the majority of the cash from debtors within 24 hours rather than a week, three weeks or even longer.

In return

 The factor issues statements on your behalf and collects payments. Your company will, however, remain responsible for reimbursing the factor for bad debts, unless you have arranged a 'non-recourse' facility. Non- recourse means that if a debtor doesn't pay, the factoring company will either suffer the loss. Hence, with non-recourse factoring you would not suffer.  You receive the balance of the invoice (less charges) once the factor receives payment.

 The factor provides regular reports on the status of your sales ledger . Creditworthiness

Using a factor can reduce the time and money you spend means that on debt collection since the factor will usually run your someone is able sales ledger for you. to repay a loan

You can use the factor's credit control system to help assess the creditworthiness of new and existing customers.

Factoring can be an efficient way to minimize the cost and risk of doing business overseas.

Leasing

Leasing is a contract between the leasing company, the lessor, and the customer (the lessee). The leasing company buys and A lease is a contractual owns the asset that the lessee requires. The customer hires the arrangement calling for asset from the leasing company and pays rental over a pre- the lesser (user) to pay determined period for the use of the asset. There are two types the lessor (owner) for use of leasing: of an asset .

 Financial Lease A capital/financial lease is a commercial arrangement Broadly put, a lease wherein: agreement is a contract between two parties, the the lessee (borrower or customer) selects an asset lessor and the lessee. (equipment, software, vehicle The lessor is the legal owner of the asset, the the lessor (finance company) purchases that asset lessee obtains the right to use the asset in return the lessee uses that asset during the lease for rental payments.

To pay by installments means that you pay according to a payment the lessee pays a series of installments or rentals for using plan with small amounts that asset of money at arranged dates. the lessor recovers a large part or almost complete cost of the asset in addition to earning interest from the rentals paid by the lessee

the lessee has the option of acquiring ownership of the asset (bargain option purchase price or paying the last rental) .

The leasing company claims writing down allowances, whilst the customer can claim both tax relief and VAT on rentals paid.

 Operating Lease

An agreement written commonly by landlords and equipment manufacturers who expect to take back the leased asset after the lease term and re-lease it to other users. The lessor gives the lessee the exclusive right to possess and use the leased asset for a specific period and under specified conditions, but retains almost all risks and rewards of the ownership. The full amount of lease payments is charged as an expense on the lessee's income statement. The maintenance of the leased asset is usually the responsibility of the lessor.

KEY POINTS

OWNERSHIP CAPITAL: amount of capital that people decided to invest in a limited company. They receive shares and dividends

DEBT FINANCING: a firm receives capital from bondholders, issues bonds and pays them periodic interest

OVERDRAFT FACILITIES: a bank gives an overdraft on a current accounts. It is a short-term loan.

LINE OF A CREDIT FROM CREDITORS: a creditor allows to buy goods or services and pays them later

GRANTS: amount of capital issued by local council and other bodies

VENTURE CAPITAL: amount of capital that people ( business angel) invest in a start-up business

FACTORING: an entrepreneur gives the sales invoices to a factor and receives , within in a determined time, 80% of the amount without waiting the correct deadline of the credits.

LEASING: an entrepreneur can use an asset in return for rental payments. He can buy the asset at the end of the contract.

PART 3

The advantages of internal sources

Financing a business through internal sources of capital involves using available sources of capital such as personal savings and business reserves to finance business expansion and operations, rather than seeking loans and credit from external sources. This approach to financing business activities is only possible when the business's principals have sufficient funds at their disposal to allocate some for their company's use.

Decision-Making Freedom

When you finance your business activities internally, you are not accountable to any outside entity. You don't need to explain your business decisions to anyone outside your company or Take some time off seek their approval before making changes or expanding. This decision-making freedom enables you to weigh personal as means to leave from well as financial considerations when choosing the right course work and take some of action for your business. For example, if you have financed time for holidays your business internally and you find yourself feeling drained and depleted, you can make the decision to take some time off or hire someone to replace yourself temporarily, even if this is not the wisest path from a strictly objective financial standpoint.

Flexibility

Internal financing allows you considerably more flexibility than outside sources of capital. If you finance your business internally and you experience a slow period that makes it difficult for you to repay a loan according to the schedule you have outlined, you can simply make an extra payment the next month. With internal financing it is usually easy to adjust payment terms in accordance with your current business cash flow and other unanticipated circumstances. The advantages of external sources of finance

Every business uses some external sources of finance. A business can grow by either using internal or external sources of finance. Internal sources of finance include all net cash flows generated by the business, such as retained profit or sale of assets. External sources of finance include bank loans, sale of a part of the business to (e.g. venture capital firms), and leasing (long-term renting of equipment).

Faster Growth

A business needs investments to grow. Even the most profitable companies cannot rely solely on reinvested profits to finance their expansion. Accordingly, a business needs to secure bank credit, partner with venture capital firms or in any other way tap external sources of finance. External finance provides the room for faster growth, allowing the company to operate on a far bigger scale, capturing new markets and providing products and services to an ever greater number of customers.

Greater Economies of Scale

Large businesses are generally more efficient than small ones. They have a greater bargaining power with suppliers and they can spread their fixed costs, such as administrative expenses, over larger sales. This results in lower costs per unit of production, which, in turn, gives the company a competitive edge in the marketplace. External sources of finance help a company grow faster, achieving the economies of scale necessary to compete with the rival firms on regional, national, or even international level.

Tax Benefits

Further, there are other benefits of that internal sources of financing don't have, such as the tax benefits of having external debt. The interest the company pays on external debt is tax deductible, as is the depreciation of any asset purchased. For this reason, the higher a company's tax rate, the more external financing or debt it is likely to have in its .

The disadvantages of using internal sources of finance

Internal sources of financing, like cash drawn from a company's operating budget or capital income to fund a project or expansion, may be the simplest form of financing; this allows the company to make decisions quickly while avoiding the wait for financing approval and avoiding the cost of paying interest or dividends. However, this type of financing has important drawbacks that may mean that it is not always the best choice.

Capital Needs

The chief concern with internal financing is that when you take money from your operating budget or capital, it leaves you with less money to manage daily expenses. Internal investment is usually used to finance small projects and investments, where the costs are small, the payback quick, and the estimated returns significant.

Knowledge Requirements

When a company evaluates whether to use internal financing for something, it has to be able to estimate with reasonable accuracy the true costs of the project and provide an accurate forecast of the investment. It also has to determine whether the return is adequate enough to justify the type of investment.

The accuracy of these calculations depends on how well the company is able to estimate its costs, predict trends and manage the budget outlined. When a company applies for external financing such as a loan, these calculations and figures are scrutinized because the creditor would stand to lose if the company later found it could not repay the debt.

Discipline

Moreover, internal financing is so easy that it leads to a lack of discipline. The company risks becoming inefficient or even complacent unless it strictly monitors the project's investment, budget and any increase in earnings that stems from the project. These actions would normally be required if the company took on debt, such as a loan, or used external financing like issuing stock. The disadvantages of using external sources of finance

Difficulties in Obtaining Loans

One of the greatest disadvantages to bank loans is that they are very difficult to obtain unless a has a substantial track record or valuable collateral such as real estate. Banks are careful to lend only to businesses that can clearly repay their loans, and they also make sure that they are able to cover losses in the event of default. Business borrowers can be required to provide personal guarantees, which means the borrower's personal assets can be seized in the event the business fails and is unable to repay all or part of a loan.

Interest

External funding sources require a return on their investment. Banks will add interest to a business loan.

Interest adds to the overall cost of the investment and can make your external funding more of a financial burden than you had originally planned.

KEY POINTS

ADVANTAGES

INTERNAL SOURCES

Decision making freedom, flexibility

EXTERNAL SOURCES

Faster growth, greater economies of scale

DISADVANTAGES

INTERNAL SOURCES

Capital needs, knowledge requirements, discipline

EXTERNAL SOURCES

Difficulties in obtaining loans, interest.

Minds map